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Table of Contents
1)
2)
3)
4)
5)
6)
7)
8)
9)
Introduction
Bond Type Specifics
Bond Pricing
Yield and Bond Price
Term Structure of Interest Rates
Duration
Convexity
Formula Cheat-Sheet
Conclusion and Resources
Introduction
In their simplest form bonds are pretty straightforward. After all, just about anybody
can comprehend the borrowing and lending of money. However, like many securities,
bonds involve some more complicated underlying concepts as they are traded and
analyzed in the market.
The goal of this tutorial is to explain the more complex aspects of fixed-income
securities. Well reinforce and review bond fundamentals such as pricing and yield,
explore the term structure of interest rates, and delve into the topics of duration,
and convexity. (Note: Although technically a bond is a fixed-income security with a
maturity of ten years or more, in this tutorial we use the term bond and fixedincome security" interchangeably.)
The information and explanations in this tutorial assume you have a basic
understanding of fixed-income securities. If you feel you need a refresher, please see
our bond basics tutorial. Please keep in mind that some concepts extend across more
than one of the advanced topics that we discuss, so there may be some overlap.
(Page 1 of 35)
Copyright 2002, Investopedia.com - All rights reserved.
1) Bond Issuers
The major determiner of a bonds credit quality, the issuer is one of the most
important characteristics of a bond. There are significant differences between bonds
issued by corporations and those issued by a state government/municipality, or
national government. In general, securities issued by the federal government has the
lowest risk of default while corporate bonds are considered more risky. Of course
there are always exceptions to the rule, so, in rare instances, a very large and stable
company could have a bond rating greater than a municipality. It is important for us
to point out, however, that, like corporate bonds, government bonds carry various
levels of risk: because all national governments are different, so are the bonds they
issue.
International bonds (government or corporate) get complicated because of differing
currencies. That is, these types of bonds are issued within a market that is foreign to
the issuers home market, but some international bonds are issued in the currency of
the foreign market and others are denominated another particular currency. Here are
some types of international bonds:
The definition of the eurobond market can be confusing because of its name.
Although the Euro is the currency used by participating European Union
countries, eurobonds refer neither to the european currency nor to a
european bond market. A eurobond instead refers to any bond that is
denominated in a currency other than that of the country in which it is issued.
Bonds in the eurobond market are categorized according to the currency in
which they are denominated. As an example, a eurobond denominated in
Japanese Yen but issued in the U.S. would be classified as a euroyen bond.
Foreign bonds are denominated in the currency of the country into which a
foreign entity issues the bond. An example of such a bond is the Samurai
bond, which is a yen-denominated bond issued in Japan by an American
company. Other popular foreign bonds include Bulldog and Yankee bonds.
Global bonds are structured so that they can be offered in both foreign and
Eurobond markets. Essentially, global bonds are similar to eurobonds but can
be offered within the country whose currency is used to denominate the bond.
As an example, a global bond denominated in yen could be sold to Japan or
any other country throughout the Eurobond market.
2) Priority
In addition to the credit quality of the issuer, the priority of the bond is a determiner
of the probability that the issuer will pay you back your money. The priority indicates
your place in line should the company default on payments. If you hold an
unsubordinated (senior) security and the company defaults, you would be first in line
to receive payment from the liquidation of their assets. On the other hand, if you
owned a subordinated (junior) debt security, you would get paid out only after the
senior debt holders have received their share.
3) Coupon Rate
Bond issuers may choose from a variety of types of coupons, or interest payments.
Straight, plain vanilla, or fixed-rate bonds pay an absolute coupon rate over a
specified period of time. Upon maturity, the last coupon payment is made
along with the par value of the bond.
Floating rate debt instruments or floaters pay a coupon rate that varies
according to the movement of the underlying benchmark. These types of
coupons could, however, be set to be a fixed percentage above, below, or
equal to the benchmark itself. Floaters typically follow benchmarks such as
the three, six, or nine-month T-bill rate or LIBOR.
Inverse floaters pay a variable coupon rate that changes in direction opposite
to that of short-term interest rates. An inverse floater subtracts the
benchmark from a set coupon rate. For example, an inverse floater that uses
LIBOR as the underlying benchmark might pay a coupon rate of a certain
percentage, say 6%, minus LIBOR.
Zero coupon or accrual bonds do not pay a coupon. Instead, these types of
bonds are issued at a deep discount and pay the full face value at maturity.
4) Redemption Features
Both investors and issuers are exposed to interest-rate risk since they are locked
into either receiving or paying a set coupon rate over a specified period of time. For
this reason, some bonds offer additional benefits to investors or more flexibility for
issuers:
Callable or a redeemable bond feature gives the bond issuer the right but not
the obligation to redeem their issue of bonds before the bonds maturitythe
issuer, however, must pay the bond holders a premium. There are two
subcategories of these types of bonds: American callable bonds and European
callable bonds. American callable bonds can be called by the issuer any time
after the call protection period while European callable bonds can be called by
the issuer only on pre-specified dates.
The optimal time for issuers to call their bonds is when the prevailing interest
rate is lower than the coupon rate they are paying on the bonds. After calling
its bonds, the company could refinance its debt by reissuing bonds at a lower
coupon rate.
Convertible bonds give bondholders the right but not the obligation to convert
their bonds into a predetermined number of shares at predetermined dates
prior to the bonds maturity. (Obviously this only applies to corporate bonds).
Puttable bonds give bondholders the right but not the obligation to sell their
bond back to the issuer at a predetermined price and date. These bonds
generally protect investors from interest-rate risk. If prevailing bond prices
are lower than the exercise par of the bond, resulting from interest rates
being higher than the bonds coupon rate, it is optimal for issuers to sell their
bond back to the issuer and reinvest their money at a higher interest rate.
Bond Pricing
It is important for prospective bond buyers to know how to determine the price of a
bond because it will indicate the yield received should the bond be purchased. In this
section, we will run through some bond price calculations for various types of bond
instruments.
Bonds can be priced at a premium, discount, or at par. If the bonds price is higher
than its par value, it would sell at a premium because its interest rate is higher than
current prevailing rates. If the bonds price is lower than its par value, the bond
would sell at a discount because its interest rate is lower than current prevailing
Here is the formula for calculating a bonds price, which uses the basic present value
(PV) formula:
C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
The succession of coupon payments to be received in the future is referred to as an
ordinary annuity, which is a series of fixed payments at set intervals over a fixed
period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first
payment of an ordinary annuity occurs one interval from the time at which the debt
security is acquired (the calculation assumes this time is the present).
You may have guessed that the bond pricing formula shown above may be tedious to
calculate since it requires us to add the present value of each future coupon
payment. But since these payments are paid at an ordinary annuity, we can use the
shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the
summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula
replaces the need to add all the present values of the future coupon. The following
diagram illustrates how present value is calculated for an ordinary annuity:
Each full moneybag on the top right represents the fixed coupon payments (future
value) received in periods 1, 2, and 3. Notice how the present value decreases for
those coupon payments that are further into the future (if you dont know why, see
Understanding the Time Value of Money): the present value of the second coupon
payment is worth less than the first coupon, and the third coupon is worth the least
amount today. The further into the future a payment is to be received, the less it is
worth todaythis is the fundamental concept for which the PV-of-ordinary-annuity
formula accounts. It calculates the sum of the present values of all future cash flows,
but, unlike the bond-pricing formula we saw earlier, it doesnt require us to add the
value of each coupon payment. (For more on calculating the time value of annuities,
see our article "Anything but Ordinary: Calculating the Present and Future Value of
Annuities.")
By incorporating the annuity model into the bond pricing formula, which requires us
to include also the present value of the par value received at maturity, we arrive at
the following formula:
Lets now go through a basic example to find the price of a plain vanilla bond.
Example 1 Calculate the price of a bond with a par value of $1000 to be paid in ten
years, a coupon rate of 10%, and a required yield of 12%. In our example well
This tutorial can be found at: http://www.investopedia.com/university/advancedbond/
(Page 6 of 35)
Copyright 2002, Investopedia.com - All rights reserved.
Not too hard was it? From the above calculation, we have determined that the bond
is selling at a discount: the bond price is less than its par value because the required
yield of the bond is greater than the coupon rate. The bond must sell at a discount to
attract investors, who could find higher interest elsewhere in the prevailing rates. In
other words, because investors can make a larger return in the market, they need an
extra incentive to invest in the bonds.
Accounting for Different Payment Frequencies
In the example above coupons were paid semi-annually, so we divided the interest
rate and coupon payments in half to represent the two payments per year. You may
be now wondering whether there is a formula that does not require steps two and
three outlined above (which are required if the coupon payments occur more than
once a year). A simple modification of the above formula will allow you to adjust
interest rates and coupon payments to calculate a bond price for any payment
frequency:
Notice that the only modification to the original formula is the addition of F, which
represents the frequency of coupon payments, or the number of times a year the
coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of
1. Should a bond pay quarterly payments, F would equal 4, and, if the bond paid
semi-annual coupons, F would equal 2.
Pricing Zero-Coupon Bonds
So what happens when there are no coupon payments? For the aptly-named zerocoupon bond, there is no coupon payment until maturity. Because of this, the
present value of annuity formula is unnecessary. You simply calculate the present
value of the par value at maturity. Heres a simple example:
Example 2(a) Lets look at how to calculate the price of a zero-coupon bond that is
maturing in five years, has a par value of $1000, and a required yield of 6%.
1. Determine the number of periods: Unless otherwise indicated, the required
yield of most zero-coupon bonds is based on a semi-annual coupon payment.
Heres why: the interest on a zero-coupon bond is equal to the difference between
purchase price and maturity value, but we need a way to compare a zero-coupon
bond to a coupon bond, so the 6% required yield must be adjusted to the equivalent
of its semi-annual coupon rate. Therefore, the number of periods for zero-coupon
bonds will be doubled, so the zero coupon bond maturing in five years would have
ten periods (5 x 2).
2. Determine the yield: The required yield of 6% must also be divided by two since
the number of periods used in the calculation has doubled. The yield for this bond is
3% (6% / 2).
3. Plug the amounts into the formula:
In this example, the interest accrued by Francesca is $11.67. If the buyer only paid
her the clean price, she would not receive the $11.67 to which she is entitled for
holding the bond for those 60 days of the 180-day coupon period.
Now you know how to calculate the price of a bond, regardless of when its next
coupon will be paid. Since bond price quotes are typically their clean prices but
buyers of bonds pay the dirty, or full price, both buyers and sellers should
understand for what amount a bond should be sold or purchased. In addition, the
tools you learned in this section will better enable you to learn the relationship
between coupon rate, required yield, and price, and the reasons why bond prices
change in the market.
So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon
rate of 5%, this is how youd calculate its current yield:
Notice how this calculation does not include any capital gains or losses the investor
would make if the bond were bought at a discount or premium. Because the bond
price compared to its par value is a factor that affects the actual current yield, the
above formula would give a slightly inaccurate answer--unless of course the investor
pays par value for the bond. To correct this, investors can modify the current yield
formula by adding the result of the current yield to the gain or loss the price gives
the investor: [(Par Value Bond Price)/Years to Maturity]. The modified current yield
formula then takes into account the discount or premium at which the investor paid
for the bond. This is the full calculation:
Lets re-calculate the yield of the bond in our first example, which matures in 30
months and has a coupon payment of $5:
The adjusted current yield of 6.84% is higher than the current yield of 5.21%
because the bonds discounted price ($95.92 instead of $100) gives the investor
more of a gain on the investment.
One thing to note, however, is whether you buy the bond between coupon
payments. If you do, remember to use the dirty price in place of the market price in
the above equation. The dirty price is what you will actually pay for the bond, but
usually the figure quoted in U.S. markets is the clean price. (We explain the
difference between clean and dirty price in the section of this tutorial on bond
pricing.)
This is due to the fact that a bond's price will be higher when it pays a coupon that is
higher than prevailing interest rates. As market interest rates increase, bond prices
decrease.
The second concept we need to review is the basic price-yield properties of bonds:
Premium bond: Coupon rate is greater than market interest rates.
Discount bond: Coupon rate is less than market interest rates.
Thirdly, remember to think of YTM as the yield a bondholder receives if he or she
reinvested all coupons received at a constant interest rate (which is the interest rate
that we are solving for). If we were to add the present values of all future cash
flows, we would end up with the market value or purchase price of the bond.
The calculation can be presented as:
OR
Remember that we are trying to find the semi-annual interest rate as the bond pays
the coupon semi-annually.
3. Guess and Check: Now for the tough part: solving for i, or the interest rate.
Rather than pick random numbers, we can start by considering the relationship
between bond price and yield. When a bond is priced at par, the interest rate is equal
to the coupon rate. If the bond is priced above par (at a premium), the coupon rate
is greater than the interest rate. In our case, the bond is priced at a discount from
par, so the annual interest rate we are seeking (like the current yield) must be
greater than the coupon rate of 5%.
Now that we know this, we can calculate a number of bond prices by plugging
various annual interest rates that are higher than 5% into the above formula. Here is
a table of the bond prices that result from a few different interest rates:
Because our bond price is $95.52, our list shows that the interest rate we are solving
for is between 6% (which gives a price of $95) and 7% (which gives a price of $98).
Now that we have found a range between which the interest rate lies, we can make
another table showing the prices that result from a series of interest rates that go up
in increments of 0.1% instead of 1.0%. Below we see the bond prices that result
from various interest rates that are between 6.0% and 7.0%:
We see then that the present value of our bond (the price) is equal to $95.92 when
we have an interest rate of 6.8%. If at this point we did not find that 6.8% gives us
the exact price we are paying for the bond, we would have to make another table
that shows the interest rates in 0.01% increments. (You can see why investors
prefer to use special programs to narrow down the interest ratesthe calculations
required to find YTM can be quite numerous!)
Calculating Yield for Callable and Puttable Bonds
Bonds with callable or puttable redemptions features have additional yield
calculations. A callable bonds valuations must account for the issuers ability to call
the bond on the call date, and the puttable bonds valuation must include the buyers
ability to sell the bond at the pre-specified put date. The yield for callable bonds is
referred to as yield-to-call, and the yield for puttable bonds is referred to as yield-toput.
Yield to call (YTC) is the interest rate that investors would receive if they held the
bond until the call date. The period until the first call is referred to as the call
protection period. Yield to call is the rate that would make the bonds present value
equal to the full price of the bond. Essentially, its calculation requires two simple
modifications to the yield-to-maturity formula:
Note that European callable bonds can have multiple call dates, and a yield to call
can be calculated for each.
Yield to put (YTP) is the interest rate that investors would receive if they held the
bond until its put date. To calculate yield to put, the same modified equation for yield
to call is used except the bond put price replaces the bond call value, and the time
until put date replaces the time until call date.
For both callable and puttable bonds, astute investors will compute both yield and all
yield-to-call/yield-to-put figures for a particular bond, and then use these figures to
estimate the expected yield. The lowest yield calculated is known as yield to worst,
which is commonly used by conservative investors when calculating their expected
This tutorial can be found at: http://www.investopedia.com/university/advancedbond/
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Copyright 2002, Investopedia.com - All rights reserved.
2) Flat Yield Curve: These curves indicate that the market environment is sending
mixed signals to investors, who are interpreting interest rate movements in various
ways. During such an environment, it is difficult for the market to determine whether
interest rates will move significantly in either direction further into the future. A flat
yield curve usually occurs when the market is making a transition that emits
different but simultaneous indications of what interest rates will do: there may be
some signals that short-term interest rates will rise and other signals that long-term
interest rates will fall. This condition will create a curve that is flatter than its normal
positive slope. When the yield curve is flat, investors can maximize their risk/return
tradeoff by choosing fixed-income securities with the least risk, or highest credit
quality. In the rare instances wherein long-term interest rates decline, a flat curve
can sometimes lead to an inverted curve.
3) Inverted Yield Curve: These yield curves are rare, and they form during
extraordinary market conditions wherein the expectations of investors are completely
the inverse of those demonstrated by the normal yield curve. In such abnormal
market environments, bonds with maturity dates further into the future are expected
to offer lower yields than bonds with shorter maturities. The inverted yield curve
indicates that the market currently expects interest rates to decline as time moves
The spot-rate curve is created by plotting the yields of zero-coupon Treasury bills
and their corresponding maturities. The spot rate given by each zero-coupon security
and the spot-rate curve are used together for determining the value of each zerocoupon component of a non-callable fixed-income security. (Remember the term
structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond.)
Since T-bills issued by the government do not have maturities greater than one year,
the bootstrapping method is used to fill in interest rates for zero-coupon securities
greater than one year. Bootstrapping is a complicated and involved process and will
not be detailed in this section (to your relief!); however, it is important to remember
that the bootstrapping method equates a T-bills value to the value of all zerocoupon components that form the security.
The Credit Spread
The credit or quality spread is the additional yield an investor receives for acquiring a
corporate bond instead of a similar federal instrument. As illustrated in the graph
below, the spread is demonstrated as the yield curve of the corporate bond is plotted
with the term structure of interest rates. Remember that the term structure of
interest rates is a gauge of the direction of interest rates and the general state of the
economy. Since corporate fixed-income securities have more risk of default than
federal securities, the prices of corporate securities are usually lower, and as such
corporate bonds usually have a higher yield.
When inflation rates are increasing (or the economy is contracting) the credit spread
between corporate and Treasury securities widens. This is because investors must be
offered additional compensation (in the form of a higher coupon rate) for acquiring
the higher risk associated with corporate bonds.
When interest rates are declining (or the economy is expanding), the credit spread
between Federal and corporate fixed-income securities generally narrows. The lower
interest rates give companies an opportunity to borrow money at lower rates, which
allows them to expand their operations and also their cash flows. When interest rates
are declining, the economy is expanding in the long run, so the risk associated with
investing in a long-term corporate bond is also generally lower.
Now you have a general understanding of the concepts and uses of the yield curve.
The yield curve is graphed using government securities, which are used as
benchmarks for fixed income investments. The yield curve in conjunction with the
credit spread is used for pricing corporate bonds. Now that you have a better
understanding of the relationship between interest rates, bond prices, and yields, we
are ready to examine the degree to which bond prices change with respect to a
change in interest rates.
Duration
The term duration, having a special meaning in the context of bonds, is a
measurement of how long in years it takes for the price of a bond to be repaid by its
internal cash flows. It is an important measure for investors to consider, as bonds
with higher durations are more risky and have higher price volatility than bonds with
lower durations.
For each of the two basic types of bonds the duration is the following:
1. Zero-coupon bond Duration is equal to its time to maturity.
The red lever above represents the four-year time period it takes for a zero coupon
to mature. The money bag balancing on the far right represents the future value of
the bond, the amount that will be paid to the bondholder at maturity. The fulcrum, or
the point holding the lever, represents duration, which must be positioned where the
red lever is balanced. The fulcrum balances the red lever at the point on the time line
when the amount paid for the bond and the cash flow received from the bond are
equal. Since the entire cash flow of a zero-coupon bond occurs at maturity, the
fulcrum is located directly below this one payment.
Duration of a Vanilla or Straight Bond
Consider a vanilla bond that pays coupons annually and matures in five years. Its
cash flows consist of five annual coupon payments and the last payment includes the
face value of the bond.
The fulcrum must now move to the right in order to balance the lever again:
Duration increases immediately on the day a coupon is paid, but throughout the life
of the bond, the duration is continually decreasing as time to the bonds maturity
decreases. The movement of time is represented above as the shortening of the red
lever: notice how the first diagram had five payment periods and the above diagram
has only four. This shortening of the timeline, however, occurs gradually, and as it
does, duration continually decreases. So, in summary, duration is decreasing as time
moves closer to maturity, but duration also increases momentarily on the day a
coupon is paid and removed from the series of future cash flowsall this occurs until
Types of Duration
There are four main types of duration calculations, each of which differ in the way
they account for factors such as interest rate changes and the bonds embedded
options or redemption features. The four types of durations are Macaulay duration,
modified duration, effective duration, and key-rate duration.
Macaulay Duration
The formula usually used to calculate a bonds basic duration is the
Macaulay duration, which was created by Frederick Macaulay in 1938 but
not commonly used until the 1970s.
Macaulay duration is calculated by adding the present value of each cash
flow by the time it is received and dividing the total by the price of the
security. The formula for Macaulay duration is as follows:
= 4.55 years
duration changes for each percentage change in yield. For bonds without
any embedded features, bond price and interest rate move in opposite
directions, so there is an inverse relationship between modified duration and
an approximate one-percentage change in yield. Because the modified
duration formula shows how a bonds duration changes in relation to interest
rate movements, the formula is appropriate for investors wishing to
measure the volatility of a particular bond. Modified duration is calculated as
the following:
OR
Lets continue analyzing Bettys bond and run through the calculation of her
modified duration. Currently her bond is selling at $1000, or par, which
translates to a yield to maturity of 5%. Remember that we calculated a
Macaulay duration of 4.55.
= 4.33 years
Our example shows that if the bonds yield changed from 5% to 6%, the
duration of the bond will have declined to 4.33 years. Because it calculates
how duration will change when interest increases by 100 basis points, the
modified duration will always be lesser than Macaulay duration.
Effective Duration
As the modified duration formula discussed above assumes that the
expected cash flows will remain constant, even if prevailing interest rates
change, it is accurate for option-free fixed-income securities. On the other
hand, cash flows from securities with embedded options or redemption
features will change when interest rates change. For calculating the duration
of these types of bonds, effective duration is the most appropriate.
Effective duration requires the use of binomial trees to calculate the optionadjusted spread (OAS). There are entire courses built around just those two
topics, so the calculations involved for effective duration is beyond the scope
of this tutorial. There are, however, many programs available to investors
wishing to calculate effective duration.
Key-Rate Duration
The final duration calculation to learn is key-rate duration, which calculates
the spot durations of each of the 11 key maturities along a spot rate
curve. (To refresh your knowledge of this curve, see the section of this
tutorial on the term structure of interest rates.) These 11 key maturities are
at the 3-month and 1, 2, 3, 5, 7, 10, 15, 20, 25, and 30-year portions of the
curve.
In essence, key-rate duration, while holding the yield for all other maturities
constant, allows the duration of a portfolio to be calculated for a one-basispoint change in interest rates. The key-rate method is most often used for
portfolios such as the bond-ladder, which consists of fixed-income securities
with differing maturities. Here is the formula for key-rate duration:
The sum of the key-rate durations along the curve is equal to the effective
duration.
best potentially capitalize on a bond with low coupon payments and a long
term to maturity, since these factors would magnify a bonds price increase.
Factor 3: Yield to Maturity (YTM)
The sensitivity of a bonds price to changes in interest rates also depends on
its yield to maturity. A bond with a high yield to maturity will display lower
price volatility than a bond with a lower yield to maturity (but similar coupon
rate and term to maturity). Yield to maturity is affected by the bonds credit
rating, so bonds with poor credit ratings will have higher yields than bonds
with excellent credit ratings. Therefore, bonds with poor credit ratings
typically display lower price volatility than bonds with excellent credit
ratings.
All three factors affect the degree to which bond price will change in the face of a
change in prevailing interest rates. These factors work together and against each
other. Consider the chart below:
So, if a bond has both a short term to maturity and a low coupon rate, its
characteristics have opposite effects on its volatility: the low coupon raises volatility
and the short term to maturity lowers volatility. The bonds volatility would then be
an average of these two opposite effects.
Immunization
As we mentioned in the above section, the interrelated factors of duration, coupon
rate, term to maturity, and price volatility are important for those investors
employing duration-based immunization strategies. These strategies aim to match
the durations of assets and liabilities within a portfolio for the purpose of minimizing
the impact of interest rates on the net worth. To create these strategies, portfolio
managers use Macaulay duration.
For example, say a bond has a two-year term with four coupons of $50 and a par
value of $1000. If the investor did not reinvest his or her proceeds at some interest
rate, he or she would have received a total of $1200 at the end of two years.
However, if the investor were to reinvest each of the bond cash flows until maturity,
Convexity
For any given bond, a graph of the relationship between price and yield is convex.
This means that the graph is curved rather than a straight-line (linear). The degree
to which the graph is curved shows how much a bonds yield changes in response to
a change in price. In this section we take a look at what affects convexity and how
investors can use it to compare bonds.
Convexity and Duration
If we graph a tangent at a particular price of the bond (touching a point on the
curved price-yield curve), the linear tangent is the bond's duration, which is shown in
red on the graph below. The exact point where the two lines touch represents
Macaulay duration. Modified duration, as we saw in the preceding section of this
tutorial, must be used to measure how duration is affected by changes in interest
rates. But modified duration does not account for large changes in price. If we were
to use duration to estimate the price resulting from a significant change in yield, the
estimation would be inaccurate. The yellow portions of the graph show the ranges in
which using duration for estimating price would be inappropriate.
Furthermore, as yield moves further from Y*, the yellow space between the actual
bond price and the prices estimated by duration (tangent line) increases.
As you can see Bond A has greater convexity than Bond B, but they both have the
same price and convexity when price equals *P and yield equals *Y. If interest rates
changed from this point by a very small amount, then regardless of the convexity,
both bonds would have approximately the same price. When yield increases by a
large amount, however, the prices of both Bond A and Bond B decrease, but Bond
Bs price decreases more than Bond As. Notice how at **Y the price of Bond A
remains higher, demonstrating that investors will have to pay more money (accept a
lower yield to maturity) for a bond with greater convexity.
What Factors Affect Convexity?
Here is a summary of the different kinds of convexities produced by different types
of bonds:
1) The graph of the price-yield relationship for a plain vanilla bond exhibits positive
convexity. The price-yield curve will increase as yield decreases, and vice versa.
Therefore, as market yields decrease, the duration increases (and vice versa).
2) In general, the higher the coupon rate, the lower the convexity of a bond. Zerocoupon bonds have the highest convexity.
3) Callable bonds will exhibit negative convexity at certain price-yield combinations.
Negative convexity means that as market yields decrease, duration decreases as
well. See the chart below for an example of a convexity diagram of callable bonds.
Remember that for callable bonds, which we discuss in our section detailing types of
bonds, modified duration can be used for an accurate estimate of bond price when
there is no chance that the bond will be called. In the chart above, the callable bond
will behave like an option-free bond at any point to the right of *Y. This portion of
the graph has positive convexity because, at yields greater than *Y, a company
would not call its bond issue: doing so would mean the company would have to
reissue new bonds at a higher interest rate. (Remember that as bond yields increase,
bond prices are decreasing and thus interest rates are increasing.) A bond issuer
would find it most optimal, or cost-effective, to call the bond when prevailing interest
rates have declined below the callable bonds interest (coupon) rate. For decreases in
yields below *Y, the graph has negative convexity as there is a higher risk that the
bond issuer will call the bond. As such, at yields below *Y, the price of a callable
bond wont rise as much as the price of a plain vanilla bond.
Bond Price
Current Yield
Macaulay Duration
Modified Duration
Yield
Yield to Call
Yield to Put
Quiz Yourself
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